Switch to Roth IRA may help &#8211; or may not

ASK ENCORE: FOCUS ON RETIREMENT

Could you provide a practical example of the financial advantage of converting a traditional IRA to a Roth IRA? In my mind, it's hard to balance the uncertainty of future tax rates against the disadvantage of giving up the tax-free compounding of the larger amount in a traditional IRA. My own rough estimates are that it's about a wash – the end result is about the same whether you convert or not.

Dave Kelch, The Villages, Fla.

Moving battered assets from a traditional Individual Retirement Account to a Roth can help some but not all investors. Several factors have to be considered, including the amount of time that will pass before you begin tapping the Roth, how you pay taxes on the conversion, and your tax bracket.

With a conversion, you do pay taxes upfront – but then future withdrawals are generally tax-free. Having your money in Roths, which have no mandatory distribution schedule, can give you more flexibility in retirement. Converting assets to a Roth IRA can also serve as a useful estate-planning technique, said Hugh Bromma, chief executive of Entrust Group in Reno, which administers self-directed IRAs. That's because your heirs would never have to pay taxes on Roth withdrawals.

In 2009, to be eligible to convert traditional IRA assets to a Roth, your modified adjusted gross income can be no more than $100,000 a year, either for an individual or a married couple filing jointly. The assets you convert wouldn't count against that limit, though they would be taxed. Starting in 2010, there are no income limits on Roth conversions, and for 2010 conversions, you can spread any taxes across 2011 and 2012.

As Dave Kelch notes in his question, it can take years for a Roth conversion to make any difference in your IRA returns. That is, unless you pay the taxes involved from a different pot of money, as some retirement planners recommend.

“The key is, you need a taxable side account from which you pay the taxes,” said Christine Fahlund, a senior financial planner for financial-services firm T. Rowe Price. “If you take the money from the traditional IRA and pay the taxes, it won't work,” because you give up the opportunity for continued tax-free growth with those investments, she said.

Another key point: your tax bracket now and in retirement. If you're in a relatively high bracket today and expect to be in a lower bracket later in life, that might be an argument against a conversion. But if you're in a relatively low tax bracket today and expect to be in a higher bracket in retirement, that might be an argument for a conversion.

Let's look at some numbers from T. Rowe Price.

First, let's say that at age 55 you transfer $50,000 to a new Roth IRA and pay $14,375 in taxes. And let's assume you face a 25 percent federal tax rate and 5 percent state tax rate, both before and after retirement. According to T. Rowe Price's calculations, total after-tax withdrawals for a retirement starting at age 65 and lasting 30 years would be $221,948. If you had left the money in a traditional IRA, you would get $208,415, or $13,533 less. So, the edge goes to converting.

But if your tax bracket turns out to be 15 percent in retirement (versus 25 percent before retiring), you would have been better off leaving your assets in the traditional IRA, which would return $229,814. That's because the big tax bite at the time of the conversion would do more damage to the nest egg in the long run than the 15 percent tax rate on withdrawals from the traditional IRA in retirement.

Conversely, if you find yourself in a 35 percent bracket in retirement (versus 25 percent before retiring), the Roth wins out, resulting in withdrawals across your retirement of $221,948, as opposed to $187,017 with the traditional IRA. In this case, you would be withdrawing money tax-free from your Roth at a time when your tax rate is higher.

One way to minimize the tax bite on conversions is to transfer small pieces of a traditional IRA to a Roth over a number of years.

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